Transfers to Skip Trusts in 2010: Not Necessarily Free from GST Tax

The
generation-skipping
transfer
(GST)
tax was
zero for
transfers
made in
2010.

Individuals
may not
have
allocated
GST
exemption
to
certain
transfers
to
trusts
in 2010.

Trusts
established
for the
benefit
of
grandchildren
and
later
generations
to which
no GST
exemption
was
allocated
in 2010
will be
subject
to GST
tax.

A
qualified
severance
may
reduce
the
amount
of GST
tax that
is due
on
distributions
from a
trust.

The
generation-skipping
transfer (GST) tax
is imposed on
certain transfers
that skip
generations, to
ensure that
property is
subject to
transfer tax at
each generational
level. The tax is
imposed at the
rate equal to the
highest federal
estate tax rate at
the time of the
transfer. Each
individual is
allowed a GST
exemption that may
be allocated to a
transfer so that
it will be exempt
from GST tax.

Under the
Economic Growth
and Tax Relief
Reconciliation
Act of 2001 (EGTRRA),1 the GST tax
was scheduled to
be repealed
entirely for
2010. The GST
tax was
retroactively
reinstated for
2010 by the Tax
Relief,
Unemployment
Insurance
Reauthorization,
and Job Creation
Act of 2010 (the
Tax Relief Act),2 but
Congress
provided that
the GST tax due
on GSTs made in
2010 is zero. It
did so by making
the applicable
rate determined
under Sec.
2641(a) zero for
GSTs made after
December 31,
2009, and before
January 1, 2011.3

All
generation-skipping
transfers are
taxed at the
“applicable
rate” (a flat
rate equal to
the maximum
federal estate
tax rate in
effect at the
time of the
generation-skipping
transfer)
multiplied by
the “inclusion ratio.”4 The
inclusion ratio
is determined by
subtracting the
“applicable
fraction” from one.5 The
applicable
fraction is
defined as the
fraction
with:

A
numerator equal
to the GST
exemption
allocated to the
trust; and

A
denominator
equal to the
value of the
property
transferred to
the trust less:

Any
federal
estate tax
and state
death
taxes
chargeable
to the
trust and
actually
recovered
from the
trust;

The
amount of
any
charitable
de­duction
allowed
under Sec.
2055, Sec.
2106, or
Sec. 2522
with
re­spect
to the
transfer;
and

In the
case of a
direct
skip, the
value of
the
portion of
the
transfer
that is a
“nontaxable gift.”6

Example
1:
In 2009, T
transferred
$100,000 to a
newly created
irrevocable trust
providing that
income is to be
accumulated for 10
years. At the end
of 10 years, the
accumulated income
is to be
distributed to
T’s
child, C,
and the trust
principal is to be
paid to T’s
grandchild, GC.
T
made an
affirmative
allocation of
$40,000 of her GST
exemption to the
trust on a timely
filed gift tax
return for 2009.
The applicable
fraction of the
trust is 2/5
($40,000 ÷
$100,000), or
0.40, and
the inclusion
ratio is 3/5 (1 −
2/5), or
0.60. In 2019, if
the maximum
federal estate tax
rate is 55%,7
the GST tax rate
applicable to the
trust is 0.33
(0.55 ×
0.60).8

The applicable
fraction for a
trust is
recomputed when
property is added
to an existing
trust.9
The numerator of
the recomputed
applicable
fraction generally
is the sum of:

The amount
of GST exemption
currently being
allocated to the
trust (if any),
plus

The value of
the “nontax
portion” of the
trust.

The
denominator of the
recomputed
applicable
fraction generally
is the value of
the trust
principal
immediately after
the occurrence of
the recomputation
event.10
The nontax portion
of the trust is
determined by
multiplying the
value of the trust
principal
immediately before
the recomputation
event by the
then-applicable
fraction.11

Example 2:T transfers
$1 million to a
newly created
trust and
allocates $1
million of GST
exemption to the
transfer. Thus,
the applicable
fraction of the
trust at that
time is 1, and
the inclusion
ratio is zero. T
subsequently
transfers
$250,000 to the
trust. Just
before the
addition, the
value of the
trust is
$1,200,000. The
nontax portion
of the trust at
the time of the
addition is
$1,200,000
(applicable
fraction of 1 ×
$1,200,000). If T has no more
GST exemption to
allocate to the
trust, the new
applicable
fraction will be
0.828 ([0 +
$1,200,000]
÷
[$1,200,000 +
$250,000]) and
the new
inclusion ratio
will be 0.172 (1 −
0.828).

Transfers to
Trusts

Many donors
create trusts
solely for the
benefit of
grandchildren
and more remote
descendants.
These trusts are
considered skip
persons because
the
beneficiaries
are in a
generation two
or more below
the generation
of the donor.12 Transfers
to these trusts
are treated as
direct skips. In
the past, a
donor’s
available GST
exemption
automatically
was allocated to
an inter vivos direct
skip, unless the
donor elected
out by paying
the GST tax with
the filing of
the gift tax
return. As a
general rule,
the donor’s GST
exemption was
allocated to all
the transfers to
such a trust so
that the trust’s
inclusion ratio
was zero.

For gifts
that are direct
skips made to
trusts in 2010,
the donor may
not have wanted
to allocate GST
exemption to the
transfer. No GST
tax would be due
on the gift so
the donor may
well have
elected out of
the automatic
allocation of
GST exemption.
Even though the
original GST
made in 2010 was
not subject to
GST tax, it is
possible that
GST tax would be
due later. If,
for example, the
donor’s
grandchildren
and
great-grandchildren
are
beneficiaries of
the trust, there
would be a GST
subject to GST
tax when
distributions
are made to
great-grandchildren
in the future (a
taxable
distribution) or
upon the
termination of
the interests of
all the
grandchildren (a
taxable
termination).

The
subsequent GST
occurs because
of the operation
of the so-called
move-down rule
of Sec. 2653(a).
The move-down
rule provides
that, when there
is a GST and the
property is held
in a trust, the
trust will be
treated as if
the transferor
were assigned to
the first
generation above
the
highest
generation of any
person who has an
interest in the
trust immediately
after the
transfer.

This rule is
used to apply
the GST tax
provisions to
subsequent
transfers from
the trust. For
example, if a
donor
transferred
property to a
trust for the
benefit of his
or her
grandchildren
and
great-grandchildren
in 2010, the GST
occurred upon
the transfer.
The GST tax with
respect to that
transfer is
zero. The donor
then moves down
to the
generation of
his or her child
for purposes of
applying the GST
tax to future
transfers from
the trust. Any
subsequent
distributions to
the donor’s
grandchildren
are not GSTs
because the
grandchildren
are no longer
skip persons based on the
donor’s new
generational assignment.
Any
distributions to
the donor’s
great-grandchildren,
however, would be
subject to GST tax
because they are
skip persons with
respect to the
donor, even with
the donor’s new
generational
assignment.

2010Transfers

If a trust
that is a skip
person is
created in 2010
and the only
transfers to it
are made in that
year, it is easy
to apply the
rules. But what
happens if the
transfer in 2010
was to a
previously
existing trust
that was a skip
person and had a
zero inclusion
ratio because
the donor had
allocated GST
exemption to all
the transfers to
the trust in the
past? If the
donor’s GST
exemption is not
allocated to the
2010 transfer to
the trust, the
2010 transfer
creates an
inclusion ratio
between zero and
one depending on
the size of the
2010 transfer
compared with
the size of the
trust before the
transfer. A
similar issue
occurs when
future transfers
are made to a
trust that is a
skip person
created in 2010,
and the donor’s
GST exemption is
automatically
allocated to
those future
transfers.

Example 3:T created a
trust in 2006
for the benefit
of her
grandchildren
and
great-grandchildren. T’s GST
exemption has
been allocated
to all transfers
to the trust in
previous years
so that the
trust has a zero
inclusion ratio.
In 2010, when
the value of the
trust is $2
million, T transfers
$500,000 to the
trust and elects
out of the
automatic
allocation of
GST exemption to
that transfer.
The applicable
fraction is
recomputed. The
numerator is the
nontax portion
of the trust
equal to $2
million, and the
denominator is
the value of the
trust after the
current transfer
or $2.5 million.
The recomputed
applicable
fraction becomes
0.8 ([0 +
$2,000,000]
÷
[$2,000,000 +
$500,000]). The
inclusion ratio
for the trust
becomes 0.2 (1 − 0.8).

When the trust
makes
distributions to
T’s
grandchildren in
the future, even
though the
inclusion ratio of
the trust is 0.2,
none of the
distributions
should be subject
to GST tax. With
respect to the
inclusion ratio
greater than zero,
T
has moved down to
her child’s
generation so the
distribution is no
longer treated as
going to a skip
person. Any
distributions to
T’s
great-grandchildren
would be subject
to an inclusion
ratio of 0.2. If
the applicable
rate is 55% in the
year of the
distribution, the
GST tax would be
equal to 11% of
the amount of the
distribution to
the
great-grandchildren
(0.2 × 0.55).

Qualified
Severance

From an
administrative, as
well as a
tactical,
perspective, it
would make sense
for the trustee to
sever such a trust
under the
qualified
severance
procedures of Sec.
2642(a)(3).13
A trustee may make
a qualified
severance of a
trust at any time,
and the resulting
trusts are treated
as separate trusts
for GST tax
purposes. If the
trust is a
discretionary
trust, the trustee
would then be able
to make
distributions from
the trusts in a
way that minimizes
the amount of GST
tax that
ultimately would
have to be
paid.

A “qualified
severance” is the
division of a
single trust (by
any means
available under
the governing
instrument or
local law) and the
creation of two or
more trusts if:
(1) the trust is
divided on a
fractional basis;
and (2) the terms
of the new trust
provide for the
same succession of
interests as the
original trust. If
the trust has an
inclusion ratio
between 0 and 1,
the division of
the trust must be
into two trusts:
one with an
inclusion ratio of
zero (0) and the
other with an
inclusion ratio of
one (1).

A trust that
has an inclusion
ratio between zero
and one because of
2010 transfers can
be severed into
two trusts with
identical terms.
The trust in the
example above with
an inclusion ratio
of 0.2 can be
severed into two
trusts. One trust
with 80% of the
trust assets at
the date of the
severance would
have an inclusion
ratio of zero. The
other trust with
20% of the trust
assets would have
an inclusion ratio
of one and a
transferor who is
treated as in the
generation of his
or her child. If
the terms of the
trust provide for
discretionary
distributions,
then any
distributions that
would be made to
the transferor’s
grandchildren
could be made from
the trust with the
inclusion ratio of
one (1). The trust
with the inclusion
ratio of zero (0)
could be preserved
to the extent
possible for
distributions to
the donor’s
great-grandchildren
or more remote
descendants.

Suppose in
the above
example that the
trust does not
appreciate but
remains at $2.5 million and
that a total of
$800,000 is
ultimately
distributed to
the
grandchildren
and nothing to
the great-grandchildren
until the trust
terminates. None
of the
distributions to
the
grandchildren
are subject to
GST tax because
the
distributions
are not to skip
persons as a
result of the
move-down rule.
Upon the
death of
the last
grandchild, the
remaining $1.7
million is
distributed to the
great-grandchildren.
If the trust is
not severed, then
there is a taxable
termination upon
the death of the
last grandchild.
If the applicable
rate at that time
is 55%, the $1.7
million balance in
the trust is taxed
at 11%. GST tax
due at that time
would be
$187,000.

If the trust is
split in a
qualified
severance,
$500,000 would be
transferred to the
trust with the
inclusion ratio of
one (1). That
trust could be
exhausted with the
distributions to
the grandchildren,
and the remaining
$300,000
distributed to the
grandchildren
would have to come
from the trust
with an inclusion
ratio of zero (0).
Upon the death of
the last
grandchild, there
would be a taxable
termination, but
there would be no
GST tax due
because the trust
has an inclusion
ratio of zero. As
a result of the
qualified
severance,
$187,000 of GST
tax is saved. This
is a very
simplistic example
with no
appreciation in
the value of the
trust assets over
the term of the
trust. The amount
of GST tax saved
could be
considerably more
if the trust
assets appreciate
over time. In any
event, it would be
worthwhile to
sever any trust
that is a skip
person if GST
exemption was
allocated to
transfers to the
trust in all years
except for the
transfers made in
2010.

Footnotes

Authors’
note: The
authors would like
to thank Eric L.
Johnson, partner,
Deloitte Tax LLP
for his
contributions to
this article.

7
Currently, the
EGTRRA provisions
as extended and
modified by the
Tax Relief Act are
scheduled to
expire at the end
of 2012, and the
maximum federal
estate tax rate is
scheduled to
return to 55%
beginning in
2013.

8
See Regs. Sec.
26.2642-1(d),
Example (1). The
authors understand
that the trust is
a GST trust and,
thus, transfers to
the trust are
indirect skips to
which T’s
remaining GST
exemption is
automatically
allocated.
However, pursuant
to Regs. Sec.
26.2632-1(b)(2)(ii),
a timely
affirmative
allocation of GST
exemption on a
gift tax return of
an amount that is
less than the
value of the
property
transferred to a
trust will prevent
the automatic
allocation of GST
exemption to the
remaining value of
the property.

13
It should be noted
that, because this
provision is part
of EGTRRA, as
extended by the
Tax Relief Act, it
is scheduled to
sunset at the end
of 2012.

EditorNotes

Justin Ransome
is a partner and
Frances Schafer is
a managing
director in the
National Tax
Office of Grant
Thornton LLP in
Washington, DC.
For more
information about
this article,
contact Mr.
Ransome at justin.ransome@us.gt.com
or Ms. Schafer at
fran.schafer@us.gt.com.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

Magazine

Don’t get lost in the fog of legislative changes, developing tax issues, and newly evolving tax planning strategies. Tax Section membership will help you stay up to date and make your practice more efficient.